Upgrading Your Asset Allocation In 2007

"A
complacent satisfaction with present knowledge is the chief bar to the pursuit
of knowledge"

B.H. Liddell Hart (1895-1970)

As mentioned in last week's article, False
Diversification May Prove Costly In 2007, long bull markets often cause
us forget about the benefits of true asset class diversification. To illustrate
the concept of false diversification, we studied a hypothetical portfolio
made up of 12 different mutual funds and ETFs, which declined by 42.49% during
the last bear market in U.S. stocks (2000-2002). Considering the S&P
500 declined by 46.34% in the same period, our hypothetical growth investor
did not have a truly diversified portfolio due to positive investment and
asset class correlations. This article will attempt to take the first step
towards building a portfolio and an ongoing management strategy tp provide
a realistic opportunity to be profitable during both bull and bear markets
in U.S. stocks.

If one of your primary objectives is to produce positive investment returns
while having a low probability of incurring losses in a reasonable time frame,
you must first understand how different asset classes behave in different economic
and financial market environments. For the purpose of this writing, the terms
economic contraction, economic slowdown, recession, and bear market are used
to describe periods of economic weakness, which have resulted in prolonged
periods of declining stock prices. The terms economic expansion and bull market
refer to periods where the economy is healthy and stock prices are moving higher.

The portfolio management strategy described here attempts to minimize exposure
to investment portfolio losses during bear markets in U.S. stocks. Figure 13
below illustrates how different asset classes performed during the last bear
market in U.S. stocks. The S&P 500 began a period of significant declines
in late August of 2000. As the U.S. stock market began to anticipate an economic
recovery, the S&P bottomed on October 7, 2002. The asset classes in Figure
13 are shown in their order of performance during the period. Gold stocks were
the biggest winners and U.S. small cap stocks had the worst performance during
the period. The data in Figure 13 is taken from the actual performance of specific
investments within each asset class. For example, the returns for gold stocks
below are those of a widely held gold stock mutual fund. Figure 13 shows returns
with dividends being reinvested. Dividend reinvestment explains why the Vanguard
500 Index Fund slightly outperformed the S&P 500 Index. Using the data
below, we know that it may be prudent to reduce exposure to holdings in emerging
market stocks and small cap stocks when the economy is entering what may be
a prolonged period of slowing economic growth.

Figure 13

Identifying All Weather Investments

Since we are attempting to build portfolios that can be profitable in both
bull and bear markets, it makes sense to identify asset classes that were able
to produce positive returns in both environments. These all weather investments
can serve as the core of any well-diversified investment portfolio, which seeks
to minimize the probability of investment losses. Within the context of the
studied portfolio management strategy, the all weather investments are used
as core building blocks to create a model economic contraction portfolio and
a model economic expansion portfolio. Every asset class (represented by a single
proxy investment) in Figure 14 below was able to produce positive returns during
the entire full market cycle, but more importantly, they were able to produce
positive returns from August of 2000 to October of 2002 when the S&P 500
(shown in red) was in a serious bear market.

Figure 14

Investors can use ETFs, such as GSG, IEF, TLT, DVY, GLD, and SLV to gain access
to a variety of asset classes.

Historical Performance vs. The Real World

Obviously, the next bear market and subsequent bull market in U.S. stocks
will be different from the most recent cycles. The strategy we are building
was developed with a respect for Mark Twain's way of looking at history:
he stated,

"The past does not repeat itself, but it rhymes."

The future will not be exactly the same as the past, but there will be meaningful
similarities. This strategy is based primarily on how asset classes, not individual
stocks, performed under different economic and market conditions. This should
make the results more relevant than if we studied how Microsoft's stock performed
under the same conditions since individual stocks can be influenced by company
specific outcomes (earnings disappointments, fraud, credit ratings, analyst
recommendations, etc).

A common criticism of any study of historical asset class correlations is
to point out that none of us know which asset classes will be the winners in
the future. While that criticism does hold water, many of the asset class correlations
presented here should remain relevant in future economic cycles. For example,
the odds are extremely high that bonds will be more desirable in an environment
where the Federal Reserve is lowering interest rates (the Federal Funds Rate).
Conversely, in the future, the odds are good that bonds will be less attractive
under conditions where the Federal Reserve is raising interest rates. The odds
are also reasonable that commodities will be more attractive in periods of
economic expansion and they will be less attractive in periods of economic
contraction.

A multiple asset class approach to investing is an excellent way to prepare
for the fact that none of us know which asset classes will be the winners in
the future. By having exposure to low or negatively correlated asset classes,
an investor will, in theory, always have some winners in their portfolio. A
prudent investor can then decide if he or she wants to increase their exposure
to the winning asset class in the early stages of a bull run. If we use gold
as an example, an investor who had a small exposure to gold (even as low as
1%) would have been one of the first to notice and profit from the gains in
early 2001. As a result, they could have made small incremental increases in
the position as it continued to be profitable. On the other hand, a one or
two asset class investor, using primarily stocks and bonds, may not even have
heard about gold's big move until it had already gone from under $300 to over
$500. Having multiple asset classes in your portfolio, even in small amounts,
enables you to be early to many of the investment parties. It also helps you
keep an open mind about where to allocate your assets. It is human nature to
defend the asset classes that are in your portfolio and dismiss the ones that
are not. How many people told themselves "gold is not a good investment" as
it moved higher while they remained on the sidelines. For those of you that
did not have gold on your radar, the trailing five-year average annual return
for precious metals funds is 35.08%. That sounds like a pretty good investment
to me when the objective is to make money.

The beauty of this strategy is that it can also help you cut back weakening
positions. As a multiple asset class investor, I am happy to peel off some
profits in profitable assets classes during periods of weakness, like gold
in May of 2006, and redeploy the money to an asset class that may be more attractive.
Using this approach, I don't really care which asset classes are making money.
My goal is to ride the long-term winners and cut back on the long-term losers
based on all the fundamental and technical information that is available. Imagine
the results if you had used this approach to help you slowly shift away from
technology stocks in 2000 towards a larger position in commodities. In over
simplified terms, you would have slowly decreased your exposure to tech stocks
because they were going down and slowly increased your exposure to commodities
because they were going up.

A multiple asset class investor must also be open to adding new asset classes
to the portfolio from time-to-time based on changing market conditions and
trends. For example, gold might not have been in a multiple asset class portfolio
in the late 1990s due to its poor performance from 1988 to 2001. A student
of the markets would have seen gold moving up in the asset class rankings in
2001 and 2002. Under this strategy, gold would have been at least considered
and monitored as a possible new addition to a multiple asset class portfolio.
Similarly, technology stocks would have been in the mix in the 1990s. As prices
of tech stocks fell and the fundamental outlook was less than encouraging,
an investor may have dropped them from the portfolio. Flexibility and an open
mind are important elements to successful implementation of any investment
strategy.

Is multiple asset class investing the cure for all your investment worries?
We all know that no such cure exists. However, research shows that there may
be a better way to build a portfolio of investments that offers real diversification
and an opportunity for improved returns. In an effort to better prepare for
2007 and beyond, I recently conducted some extensive research on the potential
benefits of investing in a wide array of asset classes, including some with
low or negative correlations to U.S. stocks. Since the study, Protecting
Your Wealth From Inflation And Investment Losses, is rather lengthy, I
will continue to summarize what the historical numbers tell us in future articles.
While there are several ways to successfully approach the investment markets,
I feel we can all gain some advantage from reviewing how different asset classes
performed in both bull and bear markets. As time permits, I will continue to
expand on these topics in the coming weeks.

Chris Ciovacco is the Chief Investment Officer for Ciovacco
Capital Management, LLC. More on the web at www.ciovaccocapital.com.

All material presented herein is believed to be reliable
but we cannot attest to its accuracy. Investment recommendations may change
and readers are urged to check with their investment counselors and tax advisors
before making any investment decisions. Opinions expressed in these reports
may change without prior notice. This memorandum is based on information available
to the public. No representation is made that it is accurate or complete. This
memorandum is not an offer to buy or sell or a solicitation of an offer to
buy or sell the securities mentioned. The investments discussed or recommended
in this report may be unsuitable for investors depending on their specific
investment objectives and financial position. Past performance is not necessarily
a guide to future performance. The price or value of the investments to which
this report relates, either directly or indirectly, may fall or rise against
the interest of investors. All prices and yields contained in this report are
subject to change without notice. This information is based on hypothetical
assumptions and is intended for illustrative purposes only. THERE ARE NO WARRANTIES,
EXPRESSED OR IMPLIED, AS TO ACCURACY, COMPLETENESS, OR RESULTS OBTAINED FROM
ANY INFORMATION CONTAINED IN THIS ARTICLE.

Ciovacco Capital Management, LLC is an independent money
management firm based in Atlanta, Georgia. CCM helps individual investors and
businesses, large & small; achieve improved investment results via research
and globally diversified investment portfolios. Since we are a fee-based firm,
our only objective is to help you protect and grow your assets. Our long-term,
theme-oriented, buy-and-hold approach allows for portfolio rebalancing from
time to time to adjust to new opportunities or changing market conditions.